- Keynes and Hicks’ normal backwardation theory: futures price is set below the future expected spot price; therefore, on average, a risk premium will accrue to futures buyers, who demand it for taking on the producers’ hedging demand (a kind of insurance premium). The theory pre-dates modern portfolio theory and its applicability is debatable. Do producers still systematically pay for hedging/ insurance?
- Basis: difference between futures price and spot price. It incorporates 1) the expected future spot price, and 2) the potential risk premium.
- Note distinction between Keynesian normal backwardation and backwardation: futures can be in normal backwardation, but not in backwardation (contango, positive basis).
- Commodity futures are not akin to direct exposure on actual commodities. Investors in actual commodities are betting on the spot price. Investors in commodities futures are betting on the expected spot (futures) price; these investors (buyers) typically get paid a risk premium. Expected movements of the spot price is not a source of return, as it is already “priced in” to the futures; however, unexpected movements impact realized returns. Nevertheless, spot and futures return series are highly correlated. Correlation rises in high spot price volatility environments. The correlation is caused by linkages between the unexpected spot price movements (expected spot price movements are already priced in).
- With rebalancing, both spot and futures returns exceed inflation, but futures returns have far exceeded spot returns. Without rebalancing (buy-and hold), spot returns have slightly trailed inflation.
- All results based on past returns and the following methodology. Commodities: a constructed index of equally-weighted, monthly rebalanced, commodities futures since 1957; some survivorship bias as some commodities dropped out due to lack of interest. Results change using different weighting schemes for commodities futures. Stocks: S&P 500. Bonds: long-term bonds.
- Commodities have exhibited comparable returns but lower volatility than stocks, and higher returns and volatility than bonds.
- Stocks have exhibited higher downside risk (higher variance and negative skewness), but the commodities have exhibited higher tail risk (higher kurtosis).
- Diversification benefits: commodities have exhibited negative correlation with stocks and bonds, more negative over longer time horizons. Also, while commodities and stocks/ bonds behave similarly over the general business cycle, they exhibit different performance over certain stages of the cycle: stock/ bond returns tend to lead commodities, and the economy.
- Commodities are (moderately) correlated with inflation (some components are included in the inflation measurement), more positive over longer horizons. Stocks and bonds are negatively correlated with inflation. Unexpected inflation affects correlations more than expected inflation.
- Commodity company stocks “behave more like stocks than commodities”: they have higher correlation to stocks (0.6) than to commodity futures (0.4).
Finished: 3-Sep-08